The Fed vs. AI

The Fed spread good cheer for stock markets on Wednesday and cut interest rates by 25bps. It didn’t stop there; it has also restarted the printing presses and has said that it will buy $40bn of Treasury Bills in the next 30 days for the purpose of maintaining ample reserves over time. A rate cut and a surge in money market liquidity was enough to see US stocks experience their best post- Fed reaction in 9 months.

Why stocks reacted so positively to the Fed

The boost to stocks was surprising, after all, two members voted for no change to rates, and only one member voted for a 50bp rate cut. The Fed is the most divided it has been since 2019. Combined with Powell leaving in May, the outlook for future Fed policy is unusually uncertain. Added to this, the Fed did not change their Dot Plot and only see one cut in 2026. Prior to this meeting, the market expected the Fed to cut twice next year. The Fed used language that suggests that it will pause before cutting rates again, and we may be near the end of this rate-cutting cycle. US interest rates are now 3.75-3.5%, which Fed chair Powell said is near the neutral rate.

The Fed turns on the liquidity taps once again

The most surprising element to this meeting was the larger than expected increase to QE. The restart to QE, or reserve management purchases, is designed to ensure that the Federal Funds rate remains within its target rate. These reserve management purchases are set at $40bn for December, and may remain elevated for the next few months, before normalizing. This to ensure the smooth running of money markets, which had shown signs of stress in recent months. However, back in 2019, the Fed started by increasing asset purchases to smooth the functioning of the repo market, and within months it added significantly more liquidity.

Many had expected stocks to sink on the back of this FOMC meeting, as a ‘hawkish cut’ was expected to spook financial markets. However, instead, stocks surged and the S&P 500 is now a mere 34 points away from a fresh record high.

Three reasons why markets reacted as they did

The dollar’s reaction was also surprising, although the Fed is expecting fewer cuts than the market, the greenback fell on Wednesday night. Added to this, Treasuries rallied and yields also declined sharply. So why did the markets not react as expected? We think there are three reasons: 1, The Fed upgraded its growth forecasts. It now expects 2026 GDP to expand by 2.3%, up from 1.8% in September. The Fed is not looking for a deeper downturn in the labour market, and it expects monetary and fiscal policy to support a resilient consumer in the coming year.

2, the surprise announcement of $40bn of Treasury bill purchases this month is great news for stocks, as it is driving yields lower and weighing on the dollar. This is a double whammy of good news for corporates, as borrowing costs are cheaper and exports become more attractive. 3, Although the Fed is ready to pause its rate cutting cycle, it is not looking to raise interest rates any time soon, and the Fed chair said that this is not the base case for members, even if inflation remains elevated. Thus, the Fed sounds confident on the US economic outlook, without the need for further rate hikes, which is positive for risk assets, and bad news for the dollar.

Gold trades like stocks once more

Moves in the gold price this evening have been interesting. The gold price surged by more than $30 on the back of the Fed meeting. Are investors buying gold just in case the Fed has got it wrong, and stagflation is on the cards? Or is gold rallying like a risk asset, and will move inline with stocks for the rest of this year? If it is the latter, then the rise in the gold price is good news for overall risk sentiment.

The return of cyclicals

The breakdown of the US stock market gainers in the aftermath of the FOMC meeting is worth noting. Materials, industrials, and consumer discretionary stocks led the S&P 500 higher on Wednesday evening. Financials, transport and health care stocks also rallied strongly, and the Russel 2000 rose by 1.3%, and made a fresh record high.

Oracle earnings fail to persuade investors about its AI ambitions

Tech stocks were the laggards, and there could be some weakness for the biggest AI names on Thursday after Oracle’s results sunk its share price. The company, which has sold $36bn in bonds and secured a $38bn debt package to fund its AI ambitions this year, posted weaker than expected revenues for last quarter. Overall, Oracle’s were mixed results, cloud revenue was roughly in line with analyst estimates at $4.1bn, a 68% increase YoY. Oracle’s cloud business is the fastest growing competitor to Amazon, Microsoft and Google. Earnings per share also beat estimates, and the companies AI-fueled RPO, or remaining performance obligations, a measure of revenue from customer contracts, rose by a staggering 440% from a year ago. Oracle said that the increase was driven by new commitments from Meta and Amazon. Although these are two solid customers, it will not placate fears that big tech’s AI investments are becoming circular, which leaves it vulnerable to a loss of investor confidence.

 Overall, strong contract growth was not enough to placate fears about AI and the huge amount of capex spending required by companies to build AI infrastructure. Oracle’s share price sunk 10% in post-market trading after the results were announced. Nvidia’s share price was down by 1.3% and even mighty Alphabet’s shares fell by 0.3%. Thus, the developments of the last 24 hours, including a rate cut and QE announcement from the Fed, along with Oracle earnings that worried investors, could be a turning point for stocks. The top performers so far this month on the S&P 500 include Dollar General and Warner Bros, whereas the weakest performers so far in December, includes companies that are linked to the AI boom. As you can see below, the equal-weighted S&P 500, which strips out the effect of big tech, has started to outperform the market cap weighted S&P 500. This theme may continue until the next Fed meeting in January.

Chart 1: A turning point, the equal-weighted S&P 500, and market-cap-weighted S&P 500, over the last 6 months.